Purpose of Accounting

Purpose of Accounting

In this article the need & purpose of accounting has been explained. Accounting is recording and reporting of financial transactions. Accounting is a fundamental requirement of every modern business. It is important to note that accounting is not only limited to business world and equally important for nonprofit and public organizations.

Main Purposes of Accounting

Some important purposes of Accounting include tracking of receivable &payable, accurate profit calculation, controlling the business, tracking of financial transactions etc. These purposes have been briefly explained below;

1.   Tracking of Receivable & Payable:

First important purpose for accounting is tracking of receivables and payable. It is technically not possible to track the account receivable and account payable without proper books of account. This tracking facilitates timely payment to the creditor and timely receipt from the customer. Thus accounting play important role in working capital management.

2.   Accurate Profit Calculation:

Another important purpose of accounting is calculation of accurate profit for business. We know profit maximization is an important aspect of the business. Therefore businessman is really interested in the accurate profit earned by the business.

3.   Controlling the Business:

Accounting serves as a basic controlling tool for a business and a business without proper accounting system is exposed to frauds & errors. Many businesses cease to exist due to poor accounting system.

4.   Tracking of Financial Transactions:

Accounting facilitates the tracking of financial transactions.  Tracking of financial transaction is required for many reasons like audit, payment to creditor, etc. Accounting or accounting record facilitates speedy tracking of financial transactions.

5.   Identification of Mistakes & Fraud:

Accounting also helps in identifying the frauds & errors in the business. Interpretation & analyses of financial results may indicate the possibilities of errors or frauds. Management investigates the fluctuation in result for possibility of fraud and mistakes.

6.   Performance Appraisal:

Another important purpose for Accounting is evaluation of performance of different manager or regions. This is done through responsibility accounting. Responsibility accounting has been explained in my other article.

7.   Future Planning:

Accounting also play important role for future planning of business. for example current revenue figure provides important bases for future sales planning & target setting.

List of purposes of Accounting

List of purposes of Accounting are as under

1.   Accounting tracks the account payable & Receivables.

2.   Accounting facilitates timely payment to creditor.

3.   Accounting helps improves working capital management.

4.   Accounting calculates accurate profit of business.

5.   Accounting Facilitates in planning of business.

6.   Accounting serves as important controlling tool for business.

Books of Accounts

Books of Accounts

Books of account are used to record the business transactions. There may be thousand of transaction (Cash & credit) during a financial year. These transactions are recorded or processed in books of accounts. Primarily there are two books of account i.e. Journal & Ledger.

Books of accounts concept are more relevant in manual book keeping. In computerized environment all accounting processing is perfumed by the accounting software. All you need to enter accurate amount in accurate heads of accounts and then accounting software automatically maintains the books of accounts.

1.    General Journal

In first place the transactions are recorded in the General Journal. In Journal transaction are recorded in chronological order. Transactions are recorded with help of debit & credit rules. There are two basic rules for double entry system. Every transaction shall have two aspects (Debit & Credit) and debit aspect must be equal to credit aspect. Thus every debit has a credit of same amount.

1.    Journal is primary book.

2.    Two aspects of a transaction are recorded.

3.    Entries are recorded in chronological order.

4.    Special journal are used for high volume of transaction like sales Journal.

2.    Special Journal

Special journals may be maintained for credit sales and credit purchases in large organizations due to high volume of transactions.  Total of such special journal is posted in General ledger (total credit purchase, total credit sales, total debtor account, total creditor account).

1.    Special Journal is a special type of Journal.

2.    Special Journal total amounts are entered in General Ledger.

3.    Special Journal form part of Double entry system.

4.    Special Journal is maintained for high volume transactions like sales Journal and purchase Journal.

3.    General Ledger

A register which contains both individual accounts and total accounts of special journals is known as General ledger. It is important note that, when there is special journals maintained in the organization, then General ledger contains the total account of debtor, total account of creditor, total account sales,  total account of purchases, and separate account for other heads. In this case individual account of creditor and customer are not part of general ledger , and those account are maintained as memorandum account.

In absence of Special journals , all accounts are separately maintained in General ledger and there is no use of total accounts.

4.    Trial Balance

Closing balance of General ledger is extracted in the form of trial balance. This balance can be extracted any time, because it is a report, which can be extracted or prepared anytime. Trial balance provides a foundation for the preparation of financial statement. It is to be noted that trial balance extracted from General ledger may require some adjustment for doubtful debt, prepaid expenses, accruals etc.

1.    Trial  balance extracted from General Ledger

2.    Trial balance is a report, which is extracted from General Ledger.

3.    Trial balance may required  adjustment  (Depreciation ,accruals etc)

5.    Financial Statements

Financial statements can be prepared from the trial balance extracted from the General ledger. like trial balance, Financial statements are also reports which can be prepared anytime. Financial statements consist of statement of financial position, statement of comprehensive income, statement of cash flows, and statement of changes in equity. These component have been explained in my other article.

Accounting Principles

Accounting Principles

Important principles of accounting are accrual, consistency, Going concern, faithful presentation, matching, Historical cost etc. These principles have been briefly explained below

1.    Accrual Principle

Accrual is an important accounting principle. Under accrual principle transactions are recorded in the period to which they relate (expenses and income is recorded in period to which these relate). It means occurrence of economic event/benefit is the most important factor for recording of transaction.

The recording of transaction must not be confused with cash payment or receipt. Accrual concept has fundamental importance for accuracy of financial statements. Matching concept can be effectively applied, where accrual system is working. Some examples of accrual concept are as under

Services received but not paid during the yeas should be recorded as current year expense irrespective of payment status of salaries. Similarly unpaid repair made during the Year shall be recorded as current year expense.

2.    Consistency Principle

Consistency is another important accounting principle. Consistency principle requires consistent presentation of items in the financial statement. Thus presentation should not be changed from one period to another.

Consistency Principle also requires continuity in accounting policies applied for the preparation of financial statements. Consistency principle ensures the comparability of financial statements. However, under following circumstance change in presentation is allowed

1.    Required by an international accounting standard.

2.    If Change improves user understanding.

Example of consistency

Particulars	2016	2015
Salaries & Allowances	40,000
Basic Salaries		25,000
Allowances		3,000

In above example, it is shown that salary presentation has been changed in 2016. Now salary is difficult to compare. Salary has increase in current year, but it is not clear that such increase is in basic salary or in allowances

3.    Faith-full presentation

Faith full presentation is another important accounting principle. Financial statement should give true picture of financial affair of the entity. Faith full presentation may be achieved by the application of following principles.

1.    Financial statement should be complete (all material transaction are reflected)

2.    Accounting policies applied should be free from management biased.

It is to be noted that faithful presentation is a time consuming and costly job.  Therefore balanced approached is required to achieve Faith-full presentation and cost for achieving faithful presentation should not exceed value of faithful presentation.

4.    Materiality Principle

Materiality is an important accounting principle. Under Materiality principle all material information should be reflected in the financial statement. There are two important factors for determining the materially of an item of financial statement i.e. size and nature of item. These both factors may be important individually or collectively for deciding Materiality of an item. Materiality concept has been explained with simple example

1.    Entertainment expenditure (material due to nature)

2.    1 million Electricity (total operating expenditure is 2 million- material due to size)

5.    Prudence Principle

Prudence is also an important accounting principle. This principle or concept has important role during the estimation process.  Prudence concept does not support any optimism (favorable reflection of financial statement).

Prudence concept requires a cautious approach toward preparation of financial statement. Prudence concept says that asset and income should not be overstated; similarly liability and expense should not be understated. Prudence concept is more relevant in deciding the provision of doubtful debt etc.

6.    Substance Over Form Principle

Substance over form is one of the most important accounting principles. This principle requires that transaction are recorded in the books of account on the bases of economic reality is more relevant than legal reality. In other word if legal form is different from the economic reality, then economic reality should be preferred. Famous example of substance over form is

1.    Financial Lease is recognized as asset (Despite ownership is not transferred)

2.    Sales and buy back ( recognized as a loan)

7.    Historical Cost Principle

Another important accounting principle or concept is historical cost. It means transaction must be recorded in the book of account on actual cost, this concept is more relevant for initial recognition, because now a days fair value recognition is also applied for some transaction recognition & reporting.(Especially at balance sheet date).

8.    Going Concern Principle

Going concern is a fundamental accounting principle .it means that Business will continue to exist for a long period at least for 12 months and accounts are prepared on the bases of this assumption. If this assumption is not valid, then financial statement are prepared using different bases.

Measurement Bases

Measurement Bases

A financial item is first measured and then recognized in the financial statement. Measurement primarily is value determination of financial item for recognition in the financial statements. There are following important measurement bases

1.    Historical Cost

2.    Market Value

3.    Present Value

4.    Current Cost

1.    Historical Cost Measurement Bases

Historical cost is an important measurement bases and widely used for recognition of financial item. It is to be noted that historical bases is widely used for initial recognition of financial items. Plant & machinery, inventory, investment all are initially recognized at historical cost bases.

2.    Fair Value Measurement Bases

Fair value is another important measurement bases used by the accountants. Other name of Fair value measurement is Market value measurement. Fair value measurement concept is used both in financial accounting and management accounting. It is to be noted that historical cost and fair value measurement bases are the most common measurement bases in the business world.

3.    Current or Replacement Cost Measurement Bases

Current cost measurement is also used by the accountants for valuing the asset. The replacing cost of an asset is used to value the asset. Therefore this measurement bases is also known replacing cost measurement. In financial accounting, current cost valuation method has little use; however this measurement method is extensively used by the management accountant in decision making.

4.    Present Value Measurement Bases

Present values are discounted value of future cash flow. There are two types of discounted cash flows used as measurement bases i.e. discounting the cash inflow and discounting the cash outflows. Cash inflows from asset are discounted to value the asset, while cash outflow are discounted to value the liability.

Objective of Financial Statements

Objective of Financial Statements

Main objective of financial statements is to provide financial information to different users of financial statement. This information helps those users for making informed economic decision. The users of financial statement are investors, lender, employees, government etc.

Some users are interested in financial performance component, while others are more interested in financial position component, and some users are interested in both financial position and financial performance component.

1.   Investor Information Needs

Investor is interested in financial statement for making future investment decision and also wants to know the performance of its current investment (return of investment). Thus prospective and current investors both are interested in financial statements.

·         Prospective investor – future investment decisions.

·         Current investor – performance of investment (Return on investment)

·         Dividend announced by the company.

 2.   Lender Information Needs

Lenders are interested in the financial statement, because they want to about the liquidity position of the entity. Thus lenders are mainly interested in statement of financial position and statement of cash flows.

3.   Employees & Trade Union

Employees are interested in financial statements to get information about the financial performance of the entity to predict possible impact thereof on their salaries. Employee wants stability of their jobs, so they may also be interested in statement of financial position.

Trade unions also frame their demands in accordance with the financial performance of the company. A stable company is also good for a career.

4.   Government

Government is obviously interested in financial statement to levy and recover the tax from the company. Government also needs financial statements to compile the national economic data i.e. overall all Growth, industry specific growth in country. This compiled data is used by government to formulate different policies like monetary policy and fiscal policy etc.

Information needs List

a.    Investor for investment decision & investment return information.

b.    Employees for salary & bonuses expectations and career planning.

c.    Lender for receiving payment of their credit and long term relationship.

d.    Government to levy & recover tax.

Structure of Financial Statement

Structure of Financial Statement

Structure of financial statements contains the following

1.    Component of financial statements.

2.    Element of financial statements.

3.    Block or section of financial statements.

4.    Items of Financial statements.

1.   Component of Financial statements

Financial statements include the following statements. These statements are known as component of financial statements.

1.    Statement of Financial position.

2.    Statement of comprehensive income.

3.    Statement of changes in equity.

4.    Statement of cash flow.

5.    Notes to the financial statements.

Statement of financial position shows the financial position or strength of the entity, while statement of comprehensive income tells about the financial performance of the entity. Statement of changes in equity shows changes in the equity account of the entity. Statement of cash flows informs about the cash inflow and flow occurred during the year.

Notes to the accounts provide further details of amount appearing on the face of financial statements.

 2.   Elements of Financial Statement

Financial statement contains five types of elements i.e. Asset, liabilities and equity belongs to statement of financial position, while income and expenses are part of statement of comprehensive income.

·         Assets      (Financial position)

·         Liabilities  (Financial Position)

·         Equity      (Financial Position)

·         Expenses  (Comprehensive Income)

·         Incomes   (Comprehensive Income)

3.   Blocks or Section of Financial Statements

Above mentioned element may be further divided into following section or blocks.

·         Assets      (Non Current & Current Assets)

·         Liabilities  (Non Current & Current Liabilities)

·         Equity      (Equity & Reserves)

·         Expenses  ( Cost of Sales, Administrative expenses, Financial Expenses )

·         Incomes   (Income & other Incomes)

4.   Items of Financial Statement

Different blocks of financial statement are further divided into items of financial statement.

Non Current Asset (Plant, Vehicles, furniture)

Current Asset (Stock, Receivable, Cash)

Non Current Liabilities (loan, Debentures)

Administrative Expenses (Salaries, Rent etc)

The above structure of financial statement has been explained below with the help of a table.

Component	Element	Blocks	Item
Financial position	Asset	Non Current Asset	Furniture
			Plant
			Vehicles

Statements of Financial position 31 December, 2016. (Component)

Liabilities                 (element)	Assets                  (element)
Non current Liabilities (block)	Non Current Asset (Block)
Loan                         (item)	Plant                     (item)
Finance lease             (item)	Machinery              (Item)